Showing papers in "The Accounting Review in 2004"

Costs of Equity and Earnings Attributes

Abstract: We examine the relation between the cost of equity capital and seven attributes of earnings: accrual quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism. We characterize the first four attributes as accounting‐based because they are typically measured using accounting information only. We characterize the last three attributes as market‐based because proxies for these constructs are typically based on relations between market data and accounting data. Based on theoretical models predicting a positive association between information quality and cost of equity, we test for and find that firms with the least favorable values of each attribute, considered individually, generally experience larger costs of equity than firms with the most favorable values. The largest cost of equity effects are observed for the accounting‐based attributes, in particular, accrual quality. These findings are robust to controls for innate determinants of the earnings attributes (firm siz...

PE Ratios, PEG Ratios, and Estimating the Implied Expected Rate of Return on Equity Capital

Abstract: I describe a model of earnings and earnings growth and I demonstrate how this model may be used to obtain estimates of the expected rate of return on equity capital. These estimates are compared with estimates of the expected rate of return implied by commonly used heuristics—viz., the PEG ratio and the PE ratio. Proponents of the PEG ratio (which is the price‐earnings [PE] ratio divided by the short‐term earnings growth rate) argue that this ratio takes account of differences in short‐run earnings growth, providing a ranking that is superior to the ranking based on PE ratios. But even though the PEG ratio may provide an improvement over the PE ratio, it is arguably still too simplistic because it implicitly assumes that the short‐run growth forecast also captures the long‐run future. I provide a means of simultaneously estimating the expected rate of return and the rate of change in abnormal growth in earnings beyond the (short) forecast horizon—thereby refining the PEG ratio ranking. The method may also...

The Influence of Analysts, Institutional Investors, and Insiders on the Incorporation of Market, Industry, and Firm‐Specific Information into Stock Prices

Abstract: We investigate the extent to which the trading and trade‐generating activities of three informed market participants—financial analysts, institutional investors, and insiders—influence the relative amount of firm‐specific, industry‐level, and market‐level information impounded into stock prices, as measured by stock return synchronicity. We find that stock return synchronicity is positively associated with analyst forecasting activities, consistent with analysts increasing the amount of industry‐level information in prices through intra‐industry information transfers. In contrast, stock return synchronicity is inversely related to insider trades, consistent with these transactions conveying firm‐specific information. Supplemental tests show that insider and institutional trading accelerate the incorporation of the firm‐specific component of future earnings news into prices alone, while analyst forecasting activity accelerates both the industry and firm‐specific component of future earnings news. Our resul...

Litigation Risk and the Financial Reporting Credibility of Big 4 versus Non‐Big 4 Audits: Evidence from Anglo‐American Countries

Abstract: Prior research suggests that Big 4 auditors provide higher quality audits in the U.S. in order to protect the firm's brand name reputation and to avoid costly litigation. In this study, we examine whether the perceived higher quality of a Big 4 audit is related to auditor litigation exposure or to reputation concerns. Specifically, we utilize an estimable proxy for financial reporting credibility—the ex ante cost of equity capital—to examine whether Big 4 auditors are perceived as providing higher quality audits (relative to non‐Big 4 auditors) in the U.S., and in the less litigious (but economically similar) environments in other Anglo‐American countries during the 1990–99 period. We find that a Big 4 audit is associated with a lower ex ante cost of equity capital for auditees in the U.S. but not in Australia, Canada, or the U.K. Our findings suggest that it is litigation exposure rather than brand name reputation protection that drives perceived audit quality.

Does Search‐Facilitating Technology Improve the Transparency of Financial Reporting?

Abstract: XBRL (eXtensible Business Reporting Language) is an emerging technology that facilitates directed searches and simultaneous presentation of related financial statement and footnote information. We investigate whether using an XBRL‐enhanced search engine helps nonprofessional financial statement users acquire and integrate related financial information when making an investment decision. We conduct our investigation in the context of recognition versus disclosure of stock option compensation. Our results reveal that many users do not access the technology, but those who do use it are better able to acquire and integrate information. Specifically, we find that when stock option accounting varies between firms, the use of an XBRL‐enhanced search engine increases the likelihood that individuals acquire information about stock option compensation disclosed in the footnotes. We also find that XBRL helps individuals integrate the implications of this information, resulting in different investment decisions betwe...

The Balanced Scorecard: Judgmental Effects of Performance Measures Linked to Strategy

Abstract: The balanced scorecard provides a framework for selecting multiple performance measures that supplement traditional financial measures with operating measures of customer satisfaction, internal processes, and learning and growth activities. An essential aspect of the balanced scorecard lies in its articulation of the linkage between performance measures and business strategy. This study conducts an experiment to assess how individuals' evaluations of the performance of business unit managers depend on strategically linked performance measures of a balanced scorecard. Statistical test results indicate that performance evaluations are influenced by strategically linked measures more than non‐linked measures only when evaluators are provided detailed information about business unit strategies. The results also confirm Lipe and Salterio's (2000) finding that evaluators rely more on common measures than on unique measures. Evaluators rely more on strategically linked measures than on common measures when they ...

R&D Expenditures and CEO Compensation

Abstract: This study investigates whether compensation committees seek to prevent opportunistic reductions in R&D expenditures. I hypothesize that changes in R&D spending are more strongly positively associated with changes in CEO compensation in two situations: (1) when the CEO approaches retirement, and (2) when the firm faces a small earnings decline or a small loss. Consistent with these hypotheses, the results indicate that the association between changes in R&D spending and changes in the value of CEO annual option grants is significantly positive in the above two situations, and insignificant otherwise. Similar results hold for changes in CEO annual total compensation. The results also show that neither situation is associated with reduced R&D spending. Overall, these findings suggest that compensation committees respond to, and effectively mitigate, potential opportunistic reductions in R&D spending.

Earnings Management and Capital Resource Allocation: Evidence from China's Accounting‐Based Regulation of Rights Issues

Abstract: From 1996 to 1998, listed companies in China were required to achieve a minimum return on equity (ROE) of 10 percent in each of the previous three years before they could apply for permission to issue additional shares. As a result of this rule, there was a heavy concentration of ROEs in the area just above 10 percent. We show that the Chinese regulators appear to have scrutinized firms using excess amounts of nonoperating income to reach the 10 percent hurdle. In addition, their ability to do so seems to have improved over time, which allows them to be better able to identify firms that subsequently performed better. However, many firms were still able to gain rights issue approval through excess nonoperating income. We show that these firms subsequently underperformed other approved firms that did not use the same practice, indicating that the Chinese regulators' objective of guiding capital resources toward the well‐performing sectors is partially compromised by earnings management.

Taxable Income, Future Earnings, and Equity Values

Abstract: We investigate the ability of a tax‐based fundamental—the ratio of tax‐to‐book income—to predict earnings growth and stock returns and to explain the earnings‐price ratio This tax fundamental reflects both temporary and permanent book‐tax differences as well as tax accruals, such as changes in the tax valuation allowance We find that the tax‐to‐book income ratio predicts subsequent five‐year earnings changes, both before and after the implementation of Statement of Financial Accounting Standards (SFAS) No 109 in 1993 For the pre‐SFAS No 109 period, the tax information is unrelated to contemporaneous earnings‐price ratios and strongly related to subsequent stock returns Conversely, for the post‐SFAS No 109 period, the tax fundamental is strongly related to contemporaneous earnings‐price ratios and only weakly related to subsequent stock returns, indicating improvement over time in investors' perceptions of the implications of the tax information for future earnings Deferred taxes, a component of ou

Determinants and Effects of Subjectivity in Incentives

Abstract: This study examines two questions: When do firms make greater use of subjectivity in awarding bonuses? What are the effects of subjectivity on employee pay satisfaction and firm performance? We examine these questions using data from a sample of 526 department managers in 250 car dealerships. First, the findings suggest that subjective bonuses are used to complement perceived weaknesses in quantitative performance measures and to provide employees insurance against downside risk in their pay. Specifically, use of subjective bonuses is positively related to: (1) the extent of long‐term investments in intangibles; (2) the extent of organizational interdependencies; (3) the extent to which the achievability of the formula bonus target is both difficult and leads to significant consequences if not met; and (4) the presence of an operating loss. Second, we find that the effects of subjective bonuses on pay satisfaction, productivity, and profitability are larger the greater the manager's tenure, consistent wit...

Earnings Manipulation Risk, Corporate Governance Risk, and Auditors' Planning and Pricing Decisions

Abstract: This paper investigates auditors' assessments of earnings manipulation risk and corporate governance risk, and their planning and pricing decisions in the presence of these identified risks. To conduct this investigation, we use engagement partners' assessments of their existing clients made during the participating public accounting firm's client continuance risk assessment process. We find that auditors plan increased effort and billing rates for clients with earnings manipulation risk, and that the positive relationships between earnings manipulation risk and both effort and billing rates are greater for clients that also have heightened corporate governance risk. These findings provide evidence that auditors assess situations involving both an aggressive management and inadequate corporate governance, and that there is a relationship between those assessments and auditors' planning and pricing decisions.

Self-Selection of Auditors and Audit Pricing in Private Firms

Abstract: Prior research has examined audit pricing for publicly held firms and provided some evidence of a Big 8 premium in pricing. We investigate audit pricing among private firms, and provide evidence that private firms do not pay such a premium on average. The relatively greater degree of dispersion in auditor choice (between Big 5 and non‐Big 5 auditors) in our large sample of privately held audit clients allows us to predict the auditor choice for each firm and to control for potential self‐selection. We reject the null hypothesis that clients are randomly allocated across Big 5 and non‐Big 5 auditors. Using standard OLS regressions, we document a Big 5 premium; however this premium vanishes once we control for self‐selection bias. Moreover, we find that client firms choosing Big 5 auditors generally would have faced higher fees had they chosen non‐Big 5 auditors, given their firm‐specific characteristics. Our results are consistent with audit markets for private firms being segmented along cost‐effective li...

Earnings Informativeness and Strategic Disclosure: An Empirical Examination of “Pro Forma” Earnings

Abstract: This paper provides evidence on the characteristics of firms that include “pro forma” earnings information in their press releases, whether the usefulness of pro forma earnings to investors varies systematically with these characteristics, and whether the investor response to pro forma earnings is consistent with market efficiency or mispricing. Using a sample of 249 press releases from 1997–99, we find that firms with low GAAP earnings informativeness are more likely to disclose pro forma earnings than other firms. We also find that strategic considerations, measured using the direction of GAAP earnings surprises, are an important determinant of pro forma reporting. In addition, our examination of the relative and incremental information content of pro forma earnings shows that investors find pro forma earnings to be more useful when GAAP earnings informativeness is low or when strategic considerations are absent. Tests of the predictive ability of pro forma earnings for future profitability and returns ...

The Market Valuation of Environmental Capital Expenditures by Pulp and Paper Companies

Abstract: The objective of this study is to examine the market valuation of environmental capital expenditure investment related to pollution abatement in the pulp and paper industry. The total environmental capital expenditure of $8.7 billion by our sample firms during 1989-2000 supports the focus on this industry. In order to be capitalized, an asset should be associated with future economic benefits. The existing environmental literature suggests that investors condition their evaluation of the future economic benefits arising from environmental capital expenditure on an assessment of the firms' environmental performance. This literature predicts the emergence of two environmental stereotypes: low-polluting firms that overcomply with existing environmental regulations, and high-polluting firms that just meet minimal environmental requirements. Our valuation evidence indicates that there are incremental economic benefits associated with environmental capital expenditure investment by low-polluting firms but not high-polluting firms. We also find that investors use environmental performance information to assess unbooked environmental liabilities, which we interpret to represent the future abatement spending obligations of high-polluting firms in the pulp and paper industry. We estimate average unbooked liabilities of $560 million for high-polluting firms, or 16.6 percent of market capitalization.

Former Audit Partners and Abnormal Accruals

Abstract: Audit clients often employ a former partner of their present auditor as an officer or a director. This “revolving door” practice presents a potential threat to auditor independence. Using the Jones (1991) model to calculate abnormal accruals for firms in 1998 and 1999, we find that firms employing former partners as officers or directors report larger signed and unsigned abnormal accruals than other firms, after controlling for other factors that plausibly affect abnormal accruals. To ensure that the results are not driven by performance characteristics of the former partner firms, we construct a performance‐matched control sample and obtain consistent results. We also observe a disproportionately higher (lower) proportion of former partner firms than expected just meeting (missing) analysts' earnings forecasts.

How Do Analysts Use Their Earnings Forecasts in Generating Stock Recommendations

Abstract: This paper examines whether valuation estimates based on analysts' earnings forecasts are consistent with their stock recommendations. Because earnings forecasts are linked to value and recommendations reflect analysts' opinions of value relative to current price, earnings forecasts and stock recommendations should be linked in a predictable manner. I consider four possible valuation models of how earnings forecasts and stock recommendations are linked. These models include two specifications of the residual income model, a price‐earnings‐to‐growth (PEG) model, and analysts' projections of long‐term earnings growth. The results provide little evidence that analysts' recommendations are explained by either residual income model specification. However, both the PEG model and analysts' projections of long‐term earnings growth explain analysts' stock recommendations. The relation between the valuation models and future returns is also examined. Analysts' projections of long‐term earnings growth have the great...

The Effects of Pro Forma Earnings Disclosures on Analysts' and Nonprofessional Investors' Equity Valuation Judgments

Abstract: This paper presents an experiment that examines the effect of pro forma earnings disclosures on the judgments of analysts (i.e., more sophisticated investors) and nonprofessional (i.e., less sophisticated) investors. In the experiment, participants developed stock price assessments after reviewing background financial information and a current earnings announcement for a company. The earnings announcement was manipulated to report only GAAP earnings in one condition and both pro forma and GAAP earnings in the other condition. Consistent with empirical evidence, the pro forma earnings in our experiment exceeded GAAP earnings. The results indicate that nonprofessional investors who received an earnings announcement that contained both pro forma and GAAP disclosures assessed a higher stock price than did nonprofessionals who received an announcement containing only GAAP disclosures. Financial analysts' stock price judgments were not affected by the pro forma disclosures. Followup analyses suggest that analys...

Predicting Firm Financial Distress: A Mixed Logit Model

Abstract: Over the past three decades the literature on financial distress prediction has largely been confined to simple multiple discriminant analysis, binary logistic or probit analysis, or rudimentary multinomial logit models (MNL). There has been a conspicuous absence of modeling innovation in this literature as well as a failure to keep abreast of important methodological developments emerging in other fields of the social sciences. In particular, there has been no recognition of major advances in discrete choice modeling over the last 15 years, which has increasingly relaxed behaviorally questionable assumptions associated with the independently and identically distributed errors (IID) condition and allowed for observed and unobserved heterogeneity. In contrast to standard logit, the mixed logit model fulfils this purpose and provides a superior framework for explanation and prediction. We explain the theoretical and econometric underpinnings of mixed logit and demonstrate its empirical usefulness in the con...

Private Information, Earnings Manipulations, and Executive Stock‐Option Exercises

Abstract: This paper investigates the decision by top‐level executives of more than 1,200 public corporations to exercise a large number of stock option awards in the period 1992–2001. We hypothesize and find that abnormally large option exercises predict stock return future performance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post‐exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre‐exercise period turns to disappointing earnings performance in the post‐exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post‐exercise period represent a reversal of inflated earnings in the pre‐exercise period. Collectively, these findings suggest that the private information used by top‐level executives to time abnormally large exercises follows from earnings ...

Value‐Glamour and Accruals Mispricing: One Anomaly or Two?

Abstract: We investigate whether the accruals anomaly is a manifestation of the glamour stock phenomenon documented in the finance literature. Value (glamour) stocks, characterized by low (high) past sales growth, high (low) book‐to‐market (B/M), high (low) earnings‐to‐price (E/P), and high (low) cash flow‐to‐price (C/P), are known to earn positive (negative) future abnormal returns. Note that “C” or cash flow is operationalized in the finance literature as earnings adjusted for depreciation. Sloan (1996) shows that firms with low (high) total accruals earn positive (negative) future abnormal returns. We find that a new variable, operating cash flows measured as earnings adjusted for depreciation and working capital accruals, scaled by price (CFO/P) captures mispricing attributed to the four traditional value‐glamour proxies and accruals. Interpretation of this finding depends on the reader's priors. If the reader believes that value‐glamour phenomenon can be operationalized only as C/P, and not CFO/P, then one wou...

An Examination of Long‐Lived Asset Impairments

Abstract: Prior research reveals that write‐offs of long‐lived assets are both large in magnitude and frequent in occurrence. Responding to calls for enhanced reporting of these items, the FASB issued SFAS No. 121, Accounting for the Impairment of Long‐Lived Assets. However, its effect on the characteristics of reported write‐offs remains unclear, as implementation requires inherently subjective estimates. Further, critics (including dissenting FASB board members and the SEC) question the standard's guidance. Motivated in part by this debate, this paper contrasts the characteristics of write‐offs reported prior versus subsequent to the issuance of SFAS No. 121. Empirical results reveal that economic factors have a weaker association with write‐offs reported after SFAS No. 121. This is consistent across macro, industry, and firm‐specific variables. Results also indicate a higher association between write‐offs and “big bath” reporting behavior after the standard's implementation, and that this “big bath” behavior mor...

How Much Will Firms Pay for Earnings That Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings

Abstract: We analyze a sample of firms accused of fraudulently overstating their earnings and examine the extent, if any, to which they paid additional income taxes on the allegedly fraudulent earnings. Based on restatements of current tax expense adjusted for the tax benefits of stock options, the evidence indicates that many firms included the overstated financial accounting income on their tax returns, thus over- paying their taxes in the process of inflating their accounting earnings. We estimate that the median firm sacrificed eight cents in additional income taxes per dollar of inflated pretax earnings. In aggregate, we estimate that the firms in our sample paid $320 million in taxes on overstated earnings of about $3.36 billion. These results in- dicate how far managers of firms are willing to go when allegedly inflating earnings.

Fair values, income measurement, and bank analysts' risk and valuation judgments

Abstract: We examine how fair‐value‐income measurement affects commercial bank equity analysts' risk and value judgments. Normatively, holding information and other underlying economics constant, bank analysts' risk and valuation assessments should distinguish between banks with different risks, but should not depend on how banks measure income. In our experiment, we vary income measurement—full‐fair‐value (all fair‐value changes recognized in income) versus piecemeal‐fair‐value (some fair‐value changes recognized in income, others disclosed in the notes). We also vary interest‐rate‐risk exposure (exposed versus hedged). We find that bank analysts' risk and value judgments distinguish banks' exposure to interest‐rate risk only under full‐fair‐value‐income measurement. Our evidence contributes to research concerned with financial performance reporting, risk, and fair‐value accounting by demonstrating that differences in income measurement affect fundamental judgments of specialist analysts. Our findings are striking...

The Balanced Scorecard: The Effects of Assurance and Process Accountability on Managerial Judgment

Abstract: The balanced scorecard is one of the major developments in management accounting in the past decade (Ittner and Larcker 2001) Lipe and Salterio (2000) find that managers ignore one of the key scorecard features, the inclusion of measures that are unique to the strategic objectives of a business unit, when making performance evaluation judgments This study identifies and tests two approaches to reducing this “common measures bias” We examine whether increasing effort via invoking process accountability (ie, requiring managers to justify to their superior their performance evaluations) and/or improving the perceived quality of the balanced scorecard measures (ie, via an independent third‐party assurance report on the balanced scorecard) increases managers' usage of unique performance measures in their evaluations Results suggest that either the requirement to justify an evaluation to a superior or the provision of an assurance report on the balanced scorecard increases the use of unique measures in

Analysts' Forecasts and Brokerage‐Firm Trading

Abstract: Using unique data on brokerage‐firm trading, I examine whether analysts' earnings forecasts and stock recommendations affect their brokerage firms' share of trading in the forecast stocks. I find that individual analyst's forecasts that differ from the consensus forecast generate significant brokerage‐firm trading in the forecast stocks in the two weeks after the forecast release date, affirming that analysts' forecasts affect their brokers' commission revenue. However, I find no evidence that analysts' forecast errors—the difference between forecast earnings and actual earnings—increase brokerage‐firm trading. This result suggests that analysts cannot generate trade for their employers simply by adding error to their forecasts. I find that buy recommendations generate relatively more trading, both buying and selling, through the analyst's brokerage firm. Collectively, these results suggest that analysts can generate higher trading commissions through their positive stock recommendations than by biasing t...

The Effects of Industry Specialization on Audit Risk Assessments and Audit‐Planning Decisions

Abstract: This study investigates the effects of industry specialization on auditors' risk assessments and audit‐planning decisions. In an experiment, auditors from different industry specializations complete a hypothetical audit case set in a specific (bank) industry, which creates either a match or a mismatch between the auditors' industry specialization and the hypothetical client's industry. Furthermore, I manipulate the industry‐specific case information to achieve differential audit risk levels. I also provide the auditors with a set of preliminary audit procedures and a constrained time budget. I find that the auditors' knowledge of the client's industry improves their audit risk assessments and directly influences the nature and the perceived quality of their audit‐planning decisions. In addition, the auditors' knowledge of the client's industry moderates the sensitivity of the auditors' planning decisions to their audit risk assessments.

The Value Relevance and Reliability of Brand Assets Recognized by U.K. Firms

Abstract: We examine the value relevance and reliability of brand assets recognized by 33 U.K. firms, and the stock price reaction to the announcement of brand capitalization. We find that brand assets are value relevant, i.e., associated with market values. However, the market capitalization rates of brands of firms with low contracting incentives are higher than those of firms with high contracting incentives to capitalize and overstate brand values. Thus, there could be substantial differences in the extent of bias or error in brand valuations of firms with different levels of contracting incentives, i.e., brand asset measures might not be reliable. The stock price reaction during the 21 days surrounding the first announcement of brand recognition is significantly positively associated with the recognized brand amount. However, the brand coefficient is only a small fraction of what would be expected if markets did not impute any value to brands before firms recognized them. Few previous value‐relevance studies h...

Managerial and Investor Responses to Disclosure Regulation: The Case of Reg FD and Conference Calls

Abstract: This paper investigates the effect of regulation that mandates open access to information on managers' disclosure choices and investors' reactions to disclosures. The recently passed Regulation FD (Reg FD) requires firms to make material disclosures broadly available. Using a sample of firms that previously restricted access to conference calls and a sample of firms that voluntarily allowed unlimited access to their calls in the pre‐Reg FD period, we examine the effect of the new rule on managers' decisions regarding the timing, use, and information content of calls, as well as the effect on investors' trading behavior during the call. Our results indicate that Reg FD had a significant negative impact on managers' decisions to continue hosting conference calls and on their decisions regarding the optimal time to hold the call. However, contrary to the concerns of many critics, the magnitudes of these changes are not large. We do not find evidence that Reg FD decreased the amount of information disclosed d...

Determinants of Control System Design in Divisionalized Firms

Abstract: We investigate two determinants of two choices in the control system of divisionalized firms, namely decentralization and use of performance measures. The two determinants are those identified in the literature as important to control system design: (1) information asymmetries between corporate and divisional managers and (2) division interdependencies. We treat decentralization and performance measurement choices as endogenous variables and examine the interrelation among these choices using a simultaneous equation model. Using data from 78 divisions, our results indicate that decentralization is positively related to the level of information asymmetries and negatively to intrafirm interdependencies, while the use of performance measures is affected by the level of interdependencies among divisions within the firm, but not by information asymmetries. We find some evidence that decentralization choice and use of performance measures are complementary.

Permanently Reinvested Foreign Earnings, Taxes, and Earnings Management

Abstract: Firms can delay financial statement recognition of U.S. taxes on repatriations by designating foreign subsidiary earnings as “permanently reinvested” under APB Opinion No. 23. This paper examines (1) whether firms use the permanently reinvested earnings (PRE) designation to manage reported earnings, and (2) whether amounts reported as permanently reinvested reflect investment and tax incentives to reinvest foreign subsidiary earnings abroad. Consistent with the prediction that firms use PRE to manage earnings, year‐to‐year changes in amounts reported as PRE are positively related to the difference between analyst forecasts and pre‐managed earnings. Additionally, changes in reported PRE are positively related to the difference between the foreign and domestic after‐tax return on assets and negatively related to the tax benefit of deductible repatriations, thus reflecting investment and tax incentives to reinvest abroad.